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Three steps to put Greece on the road to sustainability

By Richard Deitz*

Greek Prime Minister Antonis Samaras will travel to Berlin on August 24 for potentially decisive discussions with German Chancellor Angela Merkel about Greece?s rescue program. All options?presumably including a German veto over further disbursements to Greece which would trigger a Greek exit from the euro?are said to be on the table. In this high stakes game, Mrs. Merkel will need to decide whether to take a leap into the unknown?with the unquantifiable potential for a Lehman-style meltdown?or attempt to find a way to bring Greece onto a sustainable path.

As a hedge fund manager with more than fifteen years of experience in sovereign defaults and restructurings (and a track record of finding investment opportunities in these events), including Greece, I believe that Greek solvency could be re-established with minimal cost to its European partners if the official sector embraces a constructive and creative three-step approach.

The journey back will not be easy. Greece?s poor implementation of prior commitments, coupled with a deep recession and a massive deposit outflow have created a dire situation. BNP Paribas estimates Greece?s public debt will reach ?335bn by the end of 2012 (assuming continued program disbursements from the ?troika?). Meanwhile, GDP will likely fall this year by at least 6% to around ?202bn, putting debt-to-GDP at an eye-watering 166%.

This debt level should be especially alarming to Greece?s official sector creditors. Unlike in the ?Private Sector Involvement? debt restructuring earlier this year in which non-private creditors provided no debt relief, the burden of a future Greek restructuring will necessarily be borne primarily by official lenders who now hold over seventy percent of outstanding claims on Greece. If the official sector is to avoid a painful ?OSI? to match the private sector?s ?PSI?, it will need to find a way to engineer Greece back to solvency. The three core elements of such an effort (if accompanied by strict adherence by the Greek state to its adjustment program), could reduce Greece?s debt-to-GDP ratio by as much as 40% of GDP from projected levels.

First, the European Central Bank should sell at cost to the European Financial Stability Facility (or its successor, European Stability Mechanism) the ?50bn of Greek government bonds it purchased under the Securities Market Program. Controversially, the ECB wrote itself out of Greece?s PSI debt restructuring exercise and never suffered the large haircut that private sector creditors were forced to swallow on identical securities. The ECB could sell its holdings at 70 cents on the euro without incurring any losses. The EFSF, in turn, could exchange these bonds at cost for a new, longer term loan with Greece. This step could achieve a reduction of ?15bn (7.4% of GDP) in Greece?s overall indebtedness while providing Greece breathing room in terms of repayment schedule.

Next, the eurozone could sponsor, via an EFSF or ESM loan, a buyback by Greece of its ?63bn principal amount of bonds created as a result of PSI. Given Greece?s high credit risk and the persistent rumors of an imminent ?Grexit?, these bonds trade in the market at a tiny fraction of their face value. A tender offer at a price of 25 cents on the euro would represent a significant premium to current market prices and, crucially, would correspond to the losses generally recognized by bank holders through the PSI exercise. Such an offer might garner participation by as much as eighty percent of Greek bondholders. In that case, ?50bn of public debt might be replaced by ?12.5bn of a loan from the EFSF, implying ?37.5bn (18.6% of GDP) in debt reduction.

While a buyback would require fresh lending by the official sector, Greece could collateralize this loan with assets designated for privatization. The proceeds from privatization sales could be used to cancel this debt and lenders would have little risk as to ultimate repayment. In effect, this approach would create a ?force multiplier? for privatization sales?every euro raised from privatization would be able to cancel four euros of national debt.

Finally, Greece should be provided the same opportunity as Spain and other bailout recipients to transfer loans used to rescue solvent banks from the Greek state (via the Hellenic Financial Stability Fund) to the ESM once a viable eurozone-wide banking regulation framework is established. In Greece?s case, its four pillar banks have received ?18.5bn from the HFSF to date and private estimates suggest an incremental ?12bn may be required upon completion of the Blackrock Solutions loan provisioning exercise commissioned by the Bank of Greece.

Combined, these three steps could slice ?83bn (41.1% of GDP) from Greece?s sovereign debt pile. A reduction of this magnitude would move Greece close to the 120% debt-to-GDP level that has been considered the threshold of sustainability in Europe. Crucially, it could be achieved without official sector creditors realizing any losses. Faced with a very large exposure to a troubled borrower and broader challenges to the future of the euro, official sector lenders have some difficult choices to make. They could start by making some easier ones.

*Richard Deitz is the founder and president of VR Capital Group Ltd., an alternative asset manager specializing in distressed sovereign and corporate debt in emerging and developed markets with $1.5bn of assets under management.